Monetary Policy: Prosper-thy-neighbour and Beggar-thyself?

Abstract

This paper develops a general framework to analyse the welfare effects of monetary policies in an open economy, focusing on the interaction between internal and external sources of economic distortion. The internal sources are a monopolistic supply of both goods and labour, the external source is the monopoly power of a country on its terms of trade. Using the set-up developed by Obstfeld and Rogoff, we will show that (1) a home bias in consumption reduces the terms-of-trade externality and thus shifts the welfare gain of a monetary expansion towards the country where it will take place; (2) the welfare gain is more likely to be concentrated on the expanding country if domestic and foreign goods are close substitutes and if the distortions on the goods and labour markets are high; and (3) for a wide range of parameter values a domestic monetary expansion deteriorates domestic welfare (beggar-thyself) but improves welfare abroad (prosper-thy-neighbour). (JEL E40, F41, F42)